Dynamic Poaching in Credit Card Lending

The paper develops a positive theory of dynamic competition between credit card lenders, featuring balance transfers and default. Based on our theory and our quantitative results, we argue that the observed outcomes in the US credit card market are consistent with reduced effectiveness of personal bankruptcy protection, and inefficiently elevated costs of unsecured credit for intertemporal smoothing purposes. The model also delivers balance transfers as an equilibrium phenomenon. JEL: D1,D8,G2 Keywords: credit cards, personal bankruptcy, credit lines, non-exclusivity, unsecured credit, balance transfer, credit score ∗Drozd: Finance Department, The Wharton School of the University of Pennsylvania, email: [email protected]; Serrano-Padial: Department of Economics, University of Wisconsin Madison, email: [email protected]. Drozd acknowledges generous support provided by the Vanguard Research Fellowship as well as Cynthia and Bennet Golub Endowed Faculty Scholar Award. Serrano-Padial acknowledges generous support provided by a Graduate School Research Committee Award. We thank George Alessandria, V.V. Chari, Harald Cole, Dirk Krueger, Urban Jermann, Pricila Maziero, Lones Smith and Amir Yaron for valuable comments. We are grateful to Rasmus Lentz and Salvador Navarro for granting us access to computational resources at the University of Wisconsin. We thank Matthew Denes for an excellent research assistantship. All remaining errors are ours. 1 Introduction A statistical US household holds an option to draw as much as $40k in credit card funds. Perhaps not all, but a significant fraction of these funds can be used to finance day-to-day consumption, and can be defaulted on under Chapter 7 or 13 of the US personal bankruptcy law. By historic standards, this is an unprecedented level of insurance provided by the private credit markets, raising an important question whether the provision this type of insurance is efficient. By design, the institution of personal bankruptcy in the unsecured credit market is meant to provide state contingency when private contracts cannot be made state contingent. According to the theory of incomplete contracts, bankruptcy protection can result in significant welfare gains, potentially leading to an allocation that exhibits some notion of constrained efficiency or second best. The typical conditions to achieve second best are: two-sided commitment contracts that can be signed by lenders and borrowers, and default that is sufficiently costly for borrowers in the absence of any shocks that bankruptcy is intended to insure against. In practice, it has been shown that a simple form of punishment for default can come a long way in insuring particularly severe shocks like persistent job loss, or health and serious family problems (e.g. divorce, unwanted pregnancy). In terms of policy, this research has provided a powerful argument in support of some form of personal bankruptcy regulations. In the case of the credit card market, due to the two-sided commitment requirement, the above arguments are somewhat questionable. In fact, the credit card market features the most extreme form of lack of commitment on the borrower side: full non-exclusivity of contracts with increasingly popular options of balance transfers attached to more than 60% of credit card offers. In this context, a characterization of the possible distortions caused by non-exclusivity is very much needed to better understand the economic impact of personal bankruptcy protection laws. This should allow to assess potential solutions, welfare costs, and give policy makers some guidance about what the observable symptoms of the underlying inefficiencies might be. To study these questions both theoretically and quantitatively, we develop here a posiData for 2007. Source: Page 226 of H.R. 5244, the Credit Cardholder’s Bills of Rights: Providing New Protections for Consumers, Hearing Before the Subcommittee on Financial Institutions and Consumers Credit, House Committee on Financial Services, 110 Cong. 109, 226 (April 17, 2008) (testimony of Travis Plunkett, Consumer Federation of America), available at http://www.house.gov/apps/list/hearing/ financialsvcs_dem/hr041708.shtml. See, for example, Livshits, McGee & Tertilt (2006) tive theory of competition in a lending market featuring credit lines, balance transfers and default. By doing so, we hope to be able to examine more closely the conflict between noncommitment and implicit insurance provision in the context of the observed outcomes in the credit card market. Specifically, in our model borrowers use unsecured credit lines to smooth consumption intertemporally, and can default on their debts by maxing out on available credit limits. Consumers can accept multiple credit lines to optimize on the interest payments to their existing debt. Lenders observe time-varying credit-worthiness of borrowers and choose whether to extend credit and what kind of contract to offer in order to undercut incumbent lenders. Charge-­‐offs 45% Opera1ons/ Marke1ng 33% Cost of Funds 21% Fraud 1% Expenses: $73.9 Billon Interest 68% Interchange 17% Penalty fees 8% Cash advance fees 4% Annual fees 2% Other 1% Revenues: $96.5 Billion Figure 1: Credit Card Revenue and Cost Structure, 2003 (Daly (2004)). The key features of our model are generally consistent with what we see in the data. First, the income statement of the credit card industry illustrated in Figure 1 reveals that default is, in fact, an important feature of this market, and lenders must secure significant revenue sources to offset the losses associated with default. Second, the same figure shows that lenders actually rely on interest to generate the bulk of their revenue, consistent with the view that credit cards are primarily credit lines. Third, a centralized credit reporting system effectively removes any informational barriers between entrants and incumbent. Furthermore, the fact that a whopping 17% of balances are transferred per annum (Evans & Schmalensee (2005)) suggests that entry frictions are potentially small in this market. Using our model, we show that non-exclusivity of contracts creates a strategic entrantincumbent relation between lenders, resulting in a mis-allocation of both credit and implicit insurance. Both underinsurance and overinsurance are possible. The source of underinsurance